Stablecoins are typically pegged to a currency or a commodity like gold, and they use different mechanisms to maintain their price peg. The two most common methods are to maintain a pool of reserve assets as collateral or use an algorithmic formula to control the supply of a coin.

Collateralised Stablecoins

Collateralised stablecoins maintain a pool of collateral to support the coin’s value. Whenever the holder of a stablecoin wishes to cash out their tokens, an equal amount of the collateralising assets is taken from the reserves.

USD Coin (USDC) is a prime example of a collateralised stablecoin. The graph below shows USDC’s collateral reserves as of August 2022—at $54 billion, the coin’s reserves are slightly greater than its liabilities of $US53.8 billion.

USDC’s reserves are held in safe assets like cash and US Treasuries.

Unlike many stablecoins, USDC openly discloses precise information about its assets and liabilities. There has long been controversy about the reliability of the collateralising reserves regarding certain stablecoins (i.e., that the stablecoin’s liabilities are higher than its reserves).

The most prominent and oldest stablecoin is Tether (USDT). At a market cap of $66.9 billion, USDT is currently the third biggest cryptocurrency, behind Bitcoin and Ethereum (ETH). However, it has been besieged by doubt about the reliability of its reserves for years.

Stablecoins and cryptocurrencies are now under increased scrutiny by regulators in the US and around the world, including the Australian Securities and Investments Commission (ASIC).

In Oct. 2021, the Commodity Futures Trading Commission (CFTC) issued a statement ordering Tether to pay a civil penalty of $41 million for making “untrue and misleading statements” and for the fact it “misrepresented to customers and the market that Tether maintained sufficient U.S. dollar reserves to back every USDT in circulation with the ‘equivalent amount of corresponding fiat currency.’”

Tether still maintains that it has sufficient reserves to back the $66.9 billion of Tether tokens in circulation. Additionally, the company has yet to default on any redemption request.

“Our journey towards increased transparency is not finished yet,” Paolo Ardoino, Tether’s chief of technology, stated in April, pledging he would continue to assure the market that Tether is dependable.

Stablecoins can also be backed by other cryptocurrencies. A major example is DAI, an algorithmic stablecoin. While its value is tied to the U.S. dollar, it’s actually backed by Ethereum and other cryptocurrencies.

But due to the underlying collateral being in cryptocurrency, it is prone to more volatility.

Experts say the DAI stablecoin is overcollateralised, meaning the value of cryptocurrency assets held in reserves might be greater than the number of DAI stablecoins issued.

Algorithmic Stablecoins

Algorithmic stablecoins maintain their price peg via algorithms that control the supply of the token.

TerraUSD (UST) was the biggest algorithmic stablecoin, reaching a market cap of more than $18.7 billion at its peak on May 5 before it began to plummet sharply after it slipped below its peg.

TerraUSD’s price was pegged at $1 via the minting (creation) and burning (destruction) of a sister coin, Luna. There was no collateralisation, with the entire model running via this algorithmic minting and burning of Luna tokens each time a UST stablecoin was bought or sold.

This proved to be a problematic model. TerraUSD suffered what has since become known as a “death spiral,” as a wave of panic ultimately caused the crypto equivalent of a run-on–the bank in May, with a flood of selling “de-pegging” TerraUSD from its $1 price and ultimately sending the “stable” coin to close to zero, alongside its sister coin, Luna.

At this point, the fear in the markets caused Tether to slip under its 1:1 dollar peg to 94 cents on May 12.

Although not to the same extent as TerraUSD, investors worried about the reliability of reserves and whether Tether was fully collateralised.

After the Terra blockchain was officially halted and de-pegged from the US dollar on May 9, TerraUSD was rebranded and now trades under the name TerraClassicUSD (USTC). As of June 21 2023, USTC is trading at around $US0.01 or 99% lower than its supposed $US1 peg.

Stablecoins allow investors to move in and out of different cryptocurrencies while staying within the cryptocurrency realm.

“Stablecoins are used to bridge the gap between fiat currency and cryptocurrencies without the volatility,” says Richard Gardner, CEO of US-based Modulus Global. “Stablecoins also allow people from high inflation economies to store the value of their savings in an asset pegged to a more stable currency, like the US dollar.”

These coins offer the benefits of cryptocurrency, namely instant transfers and low fees, without the drawback of volatility. That means investors can hold them without worrying about wild swings in the value of their portfolios.

One prime use case for stablecoins is international bank transfers. Conventionally, this would require foreign exchange (FX) conversions with multiple banks and intermediaries. This route would then involve a series of steps and various fees and often take a few business days to complete, as opposed to a stablecoin transfer which would be instant and come with low, or zero fees.

The first method stablecoin issuers use to make money is through the straightforward charging of redemption and issuance fees.

Thereafter, it often varies depending on the type of stablecoin. For centralised issuers, this desire to make money leads to controversy surrounding the transparency of reserves, as discussed above. For many, this is the drawback of the centralised model—the fact investors holding such stablecoins are taking on counterparty risk.

Counterparty risk is the probability that the other party in the asset may not fulfil part of the deal and default on the contractual obligation.

“(Centralised) stablecoins make money through investing their dollar reserves in higher yielding asset classes, for example, commercial paper or Treasury bills,” says Ganesh Viswanath Natraj, assistant professor of finance at Warwick Business School in the UK. “In contrast, their liabilities incur zero interest.”

On the other hand, decentralised stablecoins have revenue modes that vary from protocol to protocol.

Typical examples include selling governance tokens that allow buyers to gain voting control over the stablecoin’s future or locking up funds into smart contracts on the blockchain to earn interest.

But with these investments from stablecoin issuers comes risk. The stablecoin issuer faces a trade-off.

“While investing their dollar reserves can increase profits, it also increases the risk of a (bank) run, and not having sufficient liquid reserves to meet redemptions in response to an investor panic,” Natraj says.